When it comes to money and investing, we're not always as rational as we think we are - which is why there's a whole field of study that explains our sometimes-strange behavior. Where do you, as an investor, fit in? Insight into the theory and findings of behavioral finance may help you answer this question.
Behavioral Finance: Questioning the Rationality Assumption
Much economic theory is based on the belief that individuals behave in a rational manner and that all existing information is embedded in the investment process. This assumption is the crux of the efficient market hypothesis.
But, researchers questioning this assumption have uncovered evidence that rational behavior is not always as prevalent as we might believe...
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Articles
Are you allowing the “noise” to distract you when you are about to get in or you are already in a trade? Noise can be the news, the TV, the temperature in your office, your dog Fido that keeps coming into your office, the charts or your spouse asking you a question. Noise is anything that is in that moment secondary to your trading; in other words, something that is taking your mind away from where it should be, i.e., focused only on the things that are most important to your trade. Those things for the most part are your plan, your rules and the price action. One of the ways to remain focused is to use a process of “mindfulness.” It is a process that keeps your purpose firmly on your dashboard and your intentions for the trade in...
“What’s going on here?” Sheila all but shouted silently in her head. Her plan was to use the Keltner Channel to signal a price break-out on the NQ E-mini, in tandem with the price action hitting the Demand Zone at the lower end of the channel. The set-up actually was a high probability trade as she had calculated it using her odds enhancers; and all would have been fine if only she had followed through with the plan. There she was, after having entered the trade and was now watching the price action when it began to inch downward toward her stop, which was placed 3 ticks below the distal line of the DZ. At first she felt her stomach knot, but she reassured herself that it was OK and that she would continue to follow her plan...
With the changes in the perception of Forex trading from being a high speed, high risk gamble, to being a scientifically driven investment vehicle, supported by social media, there are likely to be many more Forex traders in the coming years.
All of these will have dreams, big or small; some are destined to fail, many more will make a success of trading and if we were able to see inside the minds of each, we'd find clear reasons why some made it and others fell by the wayside.
Jump in a car for the first time, set off thinking you know what to do because you’ve been a passenger so many times and you’re heading for a crash unless you’re lucky enough to be a natural driver.
The analogy could well be applied to trading Forex where...
Of the various jobs that I have had during my twenty two year career at Charles Schwab, I have enjoyed my current role the most. I am the manager of Schwab’s educational webinar program called LiveOnline. I get to interact with fellow traders during virtual training sessions and answer their questions on a wide variety of topics. I have learned some valuable lessons over thirty years of trading that I hope to share with you in this article.
As investors and traders, our past experiences and training can influence how we approach the financial markets. As I found out myself, these experiences can be helpful in trading, but they can also stand in the way of success.
My formal academic training was as a biochemist. I did research...
Much has been written about crowd and group behavior in the investment industry, but one aspect that has received little attention is emotional contagion. As the term suggests, people can infect each other behaviorally. And in the field of investment, this can cost everyone a lot of money.
The term contagion has a negative connotation from its customarily application in the field of medicine and disease. Still, the term is very apt in the context of investment, because contagion frequently leads to irrational or imprudent behavior. It prevents "healthy" evaluations of investment opportunities, and gets in the way of sound judgment in decision-making.
Contagion leads to the classic blunders associated with following the crowd - buying...
Gambling is defined as staking something on a contingency. However, when trading is considered, gambling takes on a much more complex dynamic than the definition presents. Many traders are gambling without even knowing it - trading in a way or for a reason that is completely dichotomous with success in the markets.
In this article we will look at the hidden ways in which gambling creeps into trading practices, as well as the stimulus that may drive an individual to trade (and possibly gamble) in the first place.
Hidden Gambling Tendencies
It is quite likely that anyone who believes they don't have gambling tendencies will not happily admit to having them if it turns out they are in fact acting on gambling impulses. Yet discovering...
Trading in the financial markets is subjective and almost exclusively. There are as many approaches to the process as there are traders; and many of them are successful along with so many, many more that are not.
Additionally, trading can be defined in a number of ways. For example, “A transfer of funds from those who do not know what they are doing and have little emotional management, to the accounts of those who do know what they are doing and are exercising strong emotional management” and “Trading is a journey in self discovery” and “Trading is an art and must be practiced like practicing the medical arts or practicing law or any other endeavor that requires a high level of proficiency.” Furthermore, like medicine and law, the...
I know a trader, let’s call him Leon. He day trades Futures. He has been actively trading for several years. His profits are erratic and undependable, often going dramatically up and down in the same session. When Leon is making money his confidence soars and he feels like he is a power trader. On the other hand, when he loses money, which is more times than he cares to admit, he feels like a failure, a loser and stupid. For quite some time Leon has wondered why he can’t be consistently successful, and why his drawdowns tend to be much larger than his profits. He wonders this even though he has no Business Trade Plan, doesn’t consistently document his trades and despite having numerous rules, tends to violate them regularly. Leon...
According to traditional financial and economic theories investors are assumed to be rational actors, seeking to maximize their wealth in logical ways. But in the real world investors and traders often act irrationally and unpredictably, often to their financial detriment. Behavioral finance is a discipline that blends psychology and finance to help explain why investors act the way they do. Over the last few decades behavioral theorists have identified a set of cognitive errors repeatedly committed by financial market participants. By understanding some of behavioral finance’s key concepts, traders can avoid some of the common pitfalls that can wreak havoc on their account balances.
Loss aversion and the disposition effect
It...
Paulo breathed a heavy sigh as he thought about the next day’s preparation. He was still attempting to recover from today’s session, which was emotionally whipping him, as my grandfather used to say, “like he stole something!” He felt fragmented and frustrated; and he knew that his research and preparation for tomorrow’s trading was crucial. Paulo also knew that his state of mind was not conducive to the sharp focus of his A-Game, which was required for preparation that was not distorted by poor judgment or distracted by noisy negative thinking.
He actually had a number of mental/emotional tools that he could use when his emotional temperature was too extreme for making prudent decisions. But, he was so disgusted with his results...
The Mindset That You Brought into Trading is NOT the Mindset That Will Bring Success in Trading
The Journey Begins – Stumbling Out of the Starting Gates
Traders begin the journey into trading with high hopes. They believe, with good training and enough screen time, they will be able to master trading and achieve their dreams through trading. They practice diligently in simulation, back-test their methodology, and/or use a trading organization’s “near money” until they clearly see that they can win at this game with their own money. Confident from their past experience of hard work and ambition having paid off in the past, they assume this ethic will lead them to success in trading also. Methodically, they have trained themselves to...
The price action moved steadily upward on the 5 minute Russell E-mini chart. At that moment Stacey sighed heavily as she was in a short which was prompted by a level upon level supply zone that she had identified on the 60 minute time frame. She had placed her stop just above the top zone’s line amounting to 3 points. She had faith in her trade plan, but the price action seemed to be of another mind. It was perilously close to stopping her out. She couldn’t help but think about the many times that the price action hit her stop, took her out, then retraced to go on and hit the planned target leaving her behind and bemoaned. But, she also remembered the many other times when she gave in to the anxiety that acted like a pressure...
Have you ever heard something like: ‘The market is a battlefield, be ready to fight with all you've got’, or ‘The market is a war’, or a variation of this theme? I bet you have, it's a fairly common theme. Enemies may change, but the theme stays the same. The market maker is an enemy one day, the specialist the next, or the quant’s, the algo’ traders, the high frequency traders or the Federal Reserve traders etc. I’ve run out of names here - you may remember more. The question is: is it true - are these people really your enemy? Or, a better question might be: is the mindset - ‘that the market is a battlefield’ - one that you really want to adopt?
The reason I pose the question this way is because trading is not a purely intellectual...
How often have you seen something that upon closer examination turned out to be something very different? Or, have you ever looked at the price action and acted upon what seemed to be a perfect price pattern; then wrote your plan, executed the plan, and summarily were stopped out; only to go back to what you thought was the price pattern that now looked entirely different?! It was like a dream. What you perceived was predicated upon how you “filter” information. You interpreted what you saw through mental models of how the world appears to be. In other words, what you “see” and interpret as reality is created by internal working “models” in your mind. Mental models of the world are formed in your earliest years of development and...
Man v Machine
In 2006 I had a very interesting meeting with a Professor of Finance at a university in London where they were launching a Masters Degree in Financial Trading. We had a good discussion about the world of trading and he was very much a believer that the future of trading was automation and saw a terminator style rise of the machines occurring over the next few years. He told me that their masters program was all based around automated trading and also suggested that I might like to possibly consider a new career as, within the next few years, there would be very few human traders left for me to work with.
During the course of 2006 I worked with a lot of traders in 1-to-1 coaching and workshops, and one repeating request...
Merriam-Webster's Dictionary defines greed as simply, "... a selfish and excessive desire for more of something (as money) than is needed." Greed is often referenced as one of the main contributors to trading loss. Greed mangles the mind by distracting the trader from what matters most in the trade, which is quite frankly, to protect your capital by prudent planning and following rules. It also distorts your judgment regarding high probability strategies and effective follow-through. Additionally, it is the other side of the fear coin; that is, greed can arguably be thought of as a fear of not having "enough."
Of course, having enough is a purely subjective notion, but for the reasonable person, someone who wants more, more, more, as...
When traders lose money, they often attribute the problem to a lapse of discipline. Such a lack of consistency, however, is actually the result of many different problems--not the cause. Traders lose discipline with trading for the same reasons that dieters lose discipline with dieting or people getting in shape lose discipline with exercise. Quite simply, our moods, needs, and mind states of the moment tend to overwhelm our longer-range intentions. We pursue short-term pleasures (and avoid short-term discomfort) at the expense of longer-term rewards.
Here are some common reasons why traders (and most other human beings!) fall short of being fully intentional:
Environmental distractions and boredom cause a lack of focus - All of...
I recently participated in an online chat presentation for John Forman where I assembled my ideas into ten basic principles that have guided my thinking about the psychology of traders and the psychology of markets. In the very near future, if my testing continues to be promising, I hope to present a market indicator for swing traders that rests firmly upon these principles. In the interim, here are the five principles that pertain specifically to trading psychology and in future I will also give five principles for trading the markets.
Principle #1: Trading is a performance activity
Like the playing of a concert instrument or the playing of a sport, trading entails the application of knowledge and skills to real time performances...
Allen looked quizzically at the charts on his monitors. For the fourth time today, he had been stopped out and he had only taken five trades. But he smiled to himself despite the four losses because he knew that he had traded this entire session "as" a winner (meaning that he had planned every trade, had traded every plan and he had followed all of his rules – explicitly). He knew that he had achieved a private victory today as he also realized that it was critically important to approach his trading one day and one trade at a time. He had learned that trading requires 100% of his attention in order to focus intently on what matters most in the trade, and that to do that, he had to remain in the moment, for the moment, fully available...
I am often asked by traders I meet, "How do I become a successful trader? What does it really take?" In any endeavor - whether the goal is to become a competent trader, surgeon, athlete, psychologist, musician, lawyer, or pilot - the path is the same: Dedication to the goal, a lot of hard work, and a willingness to keep picking yourself up when you fall, over and over. I would like to be able to say it is easier than all that, but it really isn't.
Here are seven essentials needed to become a competent, successful trader. With dedicated effort, these steps can help you to eventually become a great trader:
1. Have a vision about your trading. Understand why you trade. It is never just about the money. Money can be had in any...
As with any balanced force… ying and yang… pleasure and pain… etc., it’s OPPORTUNITY and DANGER that confronts the trader in extremely volatile times.
Since the purpose of a disciplined trader is to keep you mentally and emotionally strong in your trading, I thought I’d offer 4 ‘structural’ tips to stay focused to run your trading plan.
“Structural” tips are things that you can do mechanically in your trading to better keep you on the side of calm, cool and collected, as opposed to “inner mind” tips that you should be engaged in all the time anyway… training your subconscious mind to hold the values of a disciplined trader. Knowing you must win the BATTLE WITHIN YOURSELF first, before you can win with the markets.
OK, here are some...
Amber is a well-adjusted, successful businesswoman and trader; however, she had considerable difficulties when she first began to trade. She earned a PhD in college and her nose-to-the-grindstone attitude helped her excel in business, but this attitude worked to her detriment in trading. She experienced herself wanting to trade the way she worked - endlessly, putting many deliverables on her plate at once, and barrelling through her workday. She said she liked her day this way because it gave her an edge, but when she used this same tactic in her trading, she had dismal results and it almost depleted all of her capital. She knew there had to be something driving her thinking and creating such depressing results. After working with her...
Dale grew up in a hard working farm family in Arkansas. His parents, while growing up during the Great Depression, had nearly lost their farm. That experience really changed them. They hoarded what little money they had and came to believe bad things can happen if you can’t be certain about the future. And Dale was born into this legacy.
Leaving the farm for greater opportunity, Dale became a banker in a trust department of a bank where he protected the value of assets placed under his care. He was a natural at his job of maintaining certainty in the face of threats to his clients' capital. As time went on, the bank was gobbled up and Dale was fed up. In a career change, he moved into day trading. He learned a proven methodology...
In this "information-is-power" age, you need knowledge and skill to succeed at any goal. There is a tremendous amount of Fundamental and Technical minutia involved in successful equity, futures and currency trading. However, getting that knowledge can be a daunting task. Also, your attitude regarding your internal stories about your ability to learn and assimilate knowledge can be either helpful or harmful to the process. Often, you become your own worst enemy due to those internal stories. For instance, you determine what you need to learn and to do; then you play the story in your head about how difficult it's going to be, or how you "flubbed" it up the last time you tried it. This type of internal story is called a "negative feedback...
Are your beliefs creating a barrier to your trading success?
Prior to Rodger Banister breaking the four minute mile barrier in 1954 it was a widely held belief that no human could possibly run a mile in under four minutes. The month following his feat, no less than 30 runners broke the four minute mile barrier.
What happened? Did these 30 runners suddenly develop better leg muscles or bigger lung capacities? Clearly not, what happened was far more powerful, it was the birth of a belief. Suddenly at the point of Roger Banister breaking that barrier he created beliefs within other runners that they could do the same.
We can liken his feat to when a market reaches a support or resistance level and is unable to break through that...
Apply Deep Practice and Elevate Your Trading
Many traders may believe that the reason success eludes them is due to their natural talents. They may think that their level of intelligence is not quite adequate, or their personality makeup, perceptual ability, temperament or other inborn traits are somehow lacking. But the reality is such characteristics have little to do with how successful a trader you can become. Although certain inherited characteristics may be helpful and others may pose challenges, our innate qualities in and of themselves do not determine how good we become at trading or any other performance activity. Take sport for example. Although body size in sport becomes relevant, this is the only natural...
There are many similarities between speculating in the financial markets and playing poker. Most participants in either or both endeavors would agree that both are equally challenging of one's discipline and mental acuity. In addition, understanding statistical probabilities as well as knowing who your opponent is when entering the field of battle are essential for victory in the two.
I've often heard professional poker players comment on how they love to spot "soft" or "weak" tables as a source of income. This means that the more inexperienced players there are at the table, the easier it will be for the seasoned pro to take their money. It's really no different in the trading world. Finding the consistent loser or novice trader is...
Consistent low risk profits from trading and investing is a challenge many millions of people take on, yet only a select few are ever able to attain. The objective and mechanical rules for consistent low risk profits are very simple, yet the layers of illusion keep most from ever seeing what is real in trading and investing.
The two main forms of analysis in trading and investing are technical and fundamental analysis, and they are very real. However, thinking that mastering these two forms of "conventional" analysis will lead to consistent low risk trading and investing profits is an illusion second to none. The more an individual attempts to master these types of analysis, the more they may be layering complex, subjective illusions...
Over-trading is one of the biggest mistakes you can make in financial markets. Having a great idea and acting upon it before the time is right can lead to losses, even if the idea behind the trade is truly fantastic.
Take EURUSD. Ever since the European Central Bank’s January meeting ECB President Trichet has been labelled hawkish. Anyone who watches the interest rate markets would have seen the spread between German (proxy for Eurozone) and US government bond yields start to widen in Europe’s favour. Eventually, this spread equated to EURUSD reaching 1.4000.
This sounds like a good trade since FX markets are sensitive to interest rates, but as of the start of February this level has been elusive. For those traders who put the...